For the last 40 years, Americans have lagged in recognizing the declining fortunes of their foreign rivals. In the 1970s they thought the Soviet Union was 10 feet tall -- ascendant even though corruption and inefficiency were destroying the vital organs of a decaying communist regime. In the late 1980s, they feared that Japan was going to economically overtake the United States, yet the crony capitalism, speculative madness, and political corruption evident throughout the 1980s led to the collapse of the Japanese economy in 1991.

Could the same malady have struck Americans when it comes to China? The latest news from Beijing is indicative of Chinese weakness: a persistent slowdown of economic growth, a glut of unsold goods, rising bad bank loans, a bursting real estate bubble, and a vicious power struggle at the top, coupled with unending political scandals. Many factors that have powered China's rise, such as the demographic dividend, disregard for the environment, supercheap labor, and virtually unlimited access to external markets, are either receding or disappearing.

Yet China's declining fortunes have not registered with U.S. elites, let alone the American public. President Barack Obama's much-hyped "pivot to Asia," announced last November, is premised on the continuing rise of China; the Pentagon has said that by 2020 roughly 60 percent of the Navy's fleet will be stationed in the Asia-Pacific region. Washington is also considering deploying sea-borne anti-missile systems in East Asia, a move reflecting U.S. worries about China's growing missile capabilities.

In the lead-up to the Nov. 6 U.S. presidential election, both Democrats and Republicans have emphasized perceived Chinese strength for reasons of both national security and political expediency. Democrats use China's growing economic might to call for more government investment in education and green technology. In late August, the Center for American Progress and the Center for the Next Generation, two left-leaning think tanks, released a report forecasting that China will have 200 million college graduates by 2030. The report (which also estimates India's progress in creating human capital) paints a grim picture of U.S. decline and demands decisive action. Republicans justify increasing defense spending in this era of sky-high deficits in part by citing predictions that China's military capabilities will continue to grow as the country's economy expands. The 2012 Republican Party platform, released in late August at the Republican National Convention, says, "In the face of China's accelerated military build-up, the United States and our allies must maintain appropriate military capabilities to discourage any aggressive or coercive behavior by China against its neighbors."

The disconnect between the brewing troubles in China and the seemingly unshakable perception of Chinese strength persists even though the U.S. media accurately cover China, in particular the country's inner fragilities. One explanation for this disconnect is that elites and ordinary Americans remain poorly informed about China and the nature of its economic challenges in the coming decades. The current economic slowdown in Beijing is neither cyclical nor the result of weak external demand for Chinese goods. China's economic ills are far more deeply rooted: an overbearing state squandering capital and squeezing out the private sector, systemic inefficiency and lack of innovation, a rapacious ruling elite interested solely in self-enrichment and the perpetuation of its privileges, a woefully underdeveloped financial sector, and mounting ecological and demographic pressures. Yet even for those who follow China, the prevailing wisdom is that though China has entered a rough patch, its fundamentals remain strong.

Americans' domestic perceptions influence how they see their rivals. It is no coincidence that the period in the 1970s and late 1980s when Americans missed signs of rivals' decline corresponded with intense dissatisfaction with U.S. performance (President Jimmy Carter's 1979 "malaise speech," for example). Today, a China whose growth rate is falling from 10 to 8 percent a year (for now) looks pretty good in comparison with an America where annual growth languishes at below 2 percent and unemployment stays above 8 percent. In the eyes of many Americans, things may be bad over there, but they are much worse here.

Perceptions of a strong and pushy China also persist because of Beijing's own behavior. The ruling Chinese Communist Party continues to exploit nationalist sentiments to bolster its credentials as the defender of China's national honor. Chinese state media and history textbooks have fed the younger generation such a diet of distorted, jingoistic facts, outright lies, and nationalist myths that it is easy to provoke anti-Western or anti-Japanese sentiments. Even more worrisome is Beijing's uncompromising stance on territorial disputes with America's key Asian allies, such as Japan and the Philippines. The risk that a contest over disputed maritime territories, especially in the South China Sea, could lead to real armed conflict makes many in the United States believe that they cannot let down their guard against China.

Sadly, this gap between the American perception of Chinese strength and the reality of Chinese weakness has real adverse consequences. Beijing will use China-bashing rhetoric and the strengthening U.S. defense posture in East Asia as ironclad evidence of Washington's unfriendliness. The Communist Party will blame the United States for its economic difficulties and diplomatic setbacks. Xenophobia could become an asset for a regime struggling for survival in hard times. Many Chinese already hold the United States responsible for the recent escalations in the South China Sea dispute and think the United States goaded Hanoi and Manila into confrontation.

The most consequential effect of this disconnect is the loss of an opportunity both to rethink U.S. China policy and to prepare for possible discontinuity in China's trajectory in the coming two decades. The central pillar of Washington's China policy is the continuation of the status quo, a world in which the Communist Party's rule is assumed to endure for decades. Similar assumptions underpinned Washington's policies toward the former Soviet Union, Suharto's Indonesia, and more recently Hosni Mubarak's Egypt and Muammar al-Qaddafi's Libya. Discounting the probability of regime change in seemingly invulnerable autocracies has always been an ingrained habit in Washington.

The United States should reassess the basic premises of its China policy and seriously consider an alternative strategy, one based on the assumption of declining Chinese strength and rising probability of an unexpected democratic transition in the coming two decades. Should such a change come, the geopolitical landscape of Asia would transform beyond recognition. The North Korean regime would collapse almost overnight, and the Korean Peninsula would be reunified. A regional wave of democratic transitions would topple the communist regimes in Vietnam and Laos. The biggest and most important unknown, however, is about China itself: Can a weak or weakening country of 1.3 billion manage a peaceful transition to democracy?

It is of course premature to completely write off the Communist Party's capacity for adaptation and renewal. China could come roaring back in a few years, and the United States should not ignore this possibility. But the party's demise can't be ruled out, and the current signs of trouble in China have provided invaluable clues to such a highly probable seismic shift. U.S. policymakers would be committing another strategic error of historic proportions if they miss or misread them.

By William Pesek - Aug 30, 2012
Policy makers around the world have long envied China’s ability to get big things done. A huge 4 trillion-yuan ($630 billion) stimulus plan as the global economy cratered in 2008? No problem. Marshaling banks to lend trillions more? Check. Enacting sweeping regulatory changes at a moment’s notice? You bet.

Ahhh, the good old days. Now, a once-in-a-decade leadership shift is getting in the way of the stimulus-happy policies to which investors became accustomed. The nimbleness that helped China steer around the worst of the global crisis is confronting political paralysis of the kind more often seen in Japan, Europe and the U.S. The upshot is that China’s 7.6 percent growth rate may fall more in the next 12 months than anyone expects.

It’s not that Wen Jiabao doesn’t get the extent to which the supposedly unstoppable China has hit a wall. Just as in 2009, the premier is visiting key industrial cities such as Guangdong and Zhejiang. Wen is facing dour looks from manufacturers surrounded by mounting piles of unsold goods, a rare experience for the main engine of China’s economic rise.

Factory warehouses are cluttered with excess stock, store shelves are filled beyond capacity, and dealerships are choked with cars that used to speed from showroom to road. And yet Wen’s team in Beijing has been eerily silent about how it plans to revive things. That may be because the short answer is, it doesn’t.

Obvious Ways

One problem is that China has run out of obvious ways to kick-start its $7.3 trillion economy. It was easy in 2008: Pump tens of billions of dollars into a sweeping stimulus project and 10 percent growth followed. China’s success gave markets the impression that its leaders could wave some magic wand and growth would be the result.

Magic is in short supply now. Local governments are cash- strapped and awash in debts that could turn bad. The euro zone seems locked into permanent-crisis mode while the U.S. is bogged down with debt, economic stagnation and political paralysis. China proved it can live for a few years without U.S. and European customers, but not forever.

The bigger topic is politics amid this year’s leadership shift. Instead of tackling the issues of growth and economic reform, officials are punting on big decisions. As such, we are now officially living in the “G-Zero” era that Ian Bremmer, the president of Eurasia Group in New York, described in his new book “Every Nation for Itself.”

At one time the weaker links within the Group of Seven nations were supported by the others. Those days are gone and now that China is sputtering, the G-Zero reality is upon us and manifesting itself in disturbing ways.

Take Asia’s surge of nationalism. Political scientists have loads of theories about why China, Japan and South Korea are suddenly at loggerheads: bad blood over World War II, energy needs, designs on controlling the Asian seas, the power vacuum left as the U.S. focused on two intractable wars. One theory that deserves more attention is how these countries deflect the blame for troubles at home.

In Japan, Prime Minister Yoshihiko Noda is spectacularly unpopular after raising taxes and restarting nuclear reactors that were shuttered following last year’s earthquake. Playing up territorial disputes allows him to change the subject and throw a bone to Japan’s influential right-wingers. In Seoul, President Lee Myung Bak has been embarrassed by corruption charges against his family. Fanning popular anger about South Korea’s status in Asia has shifted the national dialog.

The same strategy prevails in China. Unwelcome headlines focus on the widening gap between rich and poor, the Bo Xilai scandal, and charges that China fudges economic and pollution statistics. Turning the public’s attention to China’s former colonizers has been a political winner.

Asia’s Loss

The loser in all this is economic cooperation in Asia. (MXAP) Also on the losing side is vital economic change in China. Over the last decade, Wen and President Hu Jintao produced rapid expansion, but few of the structural reforms China needs for balanced growth in the decades ahead. State-owned enterprises and banks are more dominant than ever, producing huge misallocations of resources and priorities. Meanwhile, no effort has been made to build a market that promotes domestic consumption.

Rather than retool the economy, China is content to rely on the old fast-growth, export-driven model. The trouble is, the Wen-Hu era lulled markets into counting on the constant injections of stimulus spending that gave China a unique, yet unsustainable, foundation. If China isn’t a gigantic bubble economy, it’s one made up of many smaller bubbles -- property, stocks, exports. These are the result of spending-induced growth and imbalances that might breed trouble down the road, including inflation and a bad-loan crisis.

Traders looking for another dose of stimulus are expressing their disappointment that none seems forthcoming. The Shanghai Composite Index (SHCOMP) is down 13 percent so far this quarter. Those declines may accelerate as China’s leadership transition distracts lame-duck officials from giving markets their fix. The same goes for a world economy more devoid of growth engines than ever.

(William Pesek is a Bloomberg View columnist. The opinions expressed are his own.)

Both at the macro-economic and company level, reports suggest that Chinese companies are increasingly short of cash – and are having to resort to ever more desperate means to get hold of it. The overall picture is hard to grasp, given a scarcity of data, but the evidence is multiplying.

Take for example, short–term lending, which has mushroomed this year, as this chart shows, using official loan growth data:

As Mike Werner at Bernstein research wrote in a note:

July loan growth was once again skewed towards short-term loans as 29% of new loans were discounted bills (usually used to finance working capital and trade), well above the trailing 12-month average of 12%.

The received wisdom is that banks do not want to lend in the current environment, but they are clearly coming under pressure from companes, perhaps with high inventories or part-finished projects, that are crying out for short-term money to keep operations ticking over.

Machinery makers such as Zoomlion and Sany Heavy have been affected by fears of a cash squeeze in the construction and property development sectors. As the FT reported, Hunan-based Zoomlion, which is listed in Shenzhen and Hong Kong, asked shareholders in June for approval for new borrowing facilities – much bigger than its $12.3bn market value at the time.

The cash shortages now seem to be spreading. Analysts at Jefferies in Hong Kong noted this week that tight working capital, rising cost pressures and increased inventories have undermined earnings and cash-flows. They wrote:

“Investors should judge companies on the basis of cashflows and not earnings as the quality of profits comes under scrutiny. The recent dividend cutting may be a sign of fragile cashflow.”

Now consider two interesting items from this week’s South China Morning Post. One is a piece on what they call “triangular debt”, which involves overseas customers delaying payments typically from less than 60 days to an average of 90 days. This starves exporters of cash and limits what they can pay to their own suppliers.

It also reported on the effect of the economic slowdown on the abilities of steel, coal, power, non-ferrous metal, and machine building industries to pay suppliers and creditors.

In other industries too, as my FT colleague Simon Rabinovitch noted last week, there is a worrying build-up in inventories. This also hits cash flows as money for materials, power and labour is still going out the door, while sales are bringing in less.

But it is not just in the supply chain where cashflow strains are being felt. In a note about Chinese corporate earnings this week, analysts at CICC noted a new variable that was starting to catch investors’ attention: local authorities’ demands for more tax yuans. The analysts said that tax rates at a raft of companies had risen beyond expectations.

“Managements explained that it is because some local subsidiary had been requested by the local government to pay full enterprise tax rate this year, rather than the preferential high-and-new-tech-enterprise tax rate they had been granted with.

Why? The Companies said they had been simply told that local government needed more money from enterprises this year

All this at a time when profits are slowing. Combined industrial profits dropped 5.4 per cent in July from a year ago, the fourth month in a row that’s seen a drop, according to the National Bureau of Statistics.

Evidence of the cashflow problems can also be seen on the central bank level. Last week, the People’s Bank of China pumped a net Rmb278bn into the financial system using reverse-repurchase agreements, the biggest such cash injection since January, according to numerous sources.

Simon Derrick, currency strategist at BNY Mellon, has been looking at the cashflow pipe as a whole and pointed out in a note this week that between June of last year and June of this year China’s FX reserves grew by just 1.32 per cent.

“In contrast, the average year-on-year growth rate since 2001 has been a little over 30% while the lowest numbers prior to the latest set were 8.5% in March, 11.7% in December 2011 and 12.1% way back in March 2001 … the real change in the pattern of growth has emerged since the third quarter of last year.

He added that three factors – the euro crisis, less accommodative monetary policy in the US and a slowdown in China – explain why the pace of inflows into China has dropped so markedly.

For a country still highly reliant on exports, this cashflow problem is not only about the supply of credit and investment, which the central government can influence, but also about overseas demand, which it can’t.

Premier Wen Jiabao in his visit to Guangzhou last week talked about speeding up tax rebates and widening the range of export insurance, especially for small-scale enterprises.

Such actions along with the reverse repo measures can ease the cash crunch while avoiding a boost to credit creation for property, or stoking inflation.

But a big worry is how the cash squeeze feeds back into the banking system. Investors and rating agencies are already struggling to maintain a straight face when looking at non-performing loan data…. Without an opening up of the cash flow pipe from somewhere, it’s going to get more and more difficult for the banks to keep low-balling the numbers.

China can't continue to grow at 10+% per year. Their leadership and country is also conducting a high-flying act which could lead to a precipitous fall --- growth at all costs has resulted in massive environmental issues, the one child rule may yet have unintended consequences to population growth, rampant corruption, serious economic imbalances, blatant disregard for intellectual property rights (which is currently favorable to them, but eventually will not be), etc. ad infinitum.

It's also obvious that eventually the foreign investment will fall dramatically. It has already curtailed somewhat, but that is likely a result of the worldwide recession.

OTOH, China has engaged in some very intelligent long term planning, including serious efforts to try to lock up and guaranty supplies of natural resources such as oil, etc.

The point of the OP is well-taken, but the fact is that China is still a rising power, and rising faster than any other power. Russia has risen from the ashes, but still doesnt' pose nearly the same long term military or economic threat that China does. The US has also been very Euro-centric for its entire existence, and reorienting our focus somewhat makes perfect sense.

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"I love signature blocks on the Internet. I get to put whatever the hell I want in quotes, pick a pretend author, and bang, it's like he really said it." George Washington

China can't continue to grow at 10+% per year. Their leadership and country is also conducting a high-flying act which could lead to a precipitous fall --- growth at all costs has resulted in massive environmental issues, the one child rule may yet have unintended consequences to population growth, rampant corruption, serious economic imbalances, blatant disregard for intellectual property rights (which is currently favorable to them, but eventually will not be), etc. ad infinitum.

It's also obvious that eventually the foreign investment will fall dramatically. It has already curtailed somewhat, but that is likely a result of the worldwide recession.

OTOH, China has engaged in some very intelligent long term planning, including serious efforts to try to lock up and guaranty supplies of natural resources such as oil, etc.

The point of the OP is well-taken, but the fact is that China is still a rising power, and rising faster than any other power. Russia has risen from the ashes, but still doesnt' pose nearly the same long term military or economic threat that China does. The US has also been very Euro-centric for its entire existence, and reorienting our focus somewhat makes perfect sense.

Well put. I haven't found the article I wanted to post but there are severe strains between laborers and employers and govt.

The era of no workers' rights and low pay in China are cokming to an end. Strikes are becoming more common and the govt has had limited abilty to stop them.